Friday, April 07, 2006

Another Bank of the United States?

During the transformation from economic worry wart to gold bug a person almost invariably reads about the English "South Sea Bubble" and the French "Mississippi Bubble." Those of us who felt the Nasdaq was something of a bubble were quick to point out the similarities between the United States of 1999 and France and England of the early 18th Century. After a few years of reading I now believe the comparison was far less strong than I previously thought. While each instance was an example of excess liquidity fueled equity market madness, there were significant differences.

The South Sea Bubble had its South Sea Company. The MIssissippi Bubble had its Mississippi Company (La Compagnie d'Occident). But the Nasdaq bubble did not have a company or corporation that played the same role.

In both France and England of the early 18th Century, the two respective companies ended up taking ownership of the national public debt in exchange for shares of stock. In that regard, the Mississippi Company and the South Sea Company share similarities with the First Bank of the United States, admittedly with different endings.

In early 18th Century France and England, as in late 18th Century America the need to repay war debts loomed large over the respective governments. In the case of early 18th Century Europe the War of the Spanish Succession had depleted French and English Treasuries while the American Revolution left the new nation deep in debt.

Hamilton's controversial Bank of the United States, like the South Sea and Mississippi Companies assumed the national debt. Unlike the European examples, Hamilton's Bank stayed on the path of what relative to today would be very sound money.

When I read the executive summary of the Hamilton Project yesterday and its evocation of the nation's first Treasury Secretary as a genius
with Larry Summers' idea of a "hedge fund" to manage excess foreign reserves in mind, I couldn't help but wonder if the new plan to deal with a war increased national debt would be a rehash of the old, but successful plan.

To the extent the Federal Government of the United States proves as incapable of repaying the debt as the French Monarchy and English Parliament of the early 18th Century, perhaps the next step is ceding control of the debt to a private institution, like another Bank of the United States, although I imagine it would be easier to use, as per Mr. Summers, the IMF or perhaps, the Federal Reserve Bank of NY after modifying its charter.

When I wrote of an approaching end game yesterday it was with this view in mind. At some point, either the US will admit it will repudiate its debt, foreign holders of that debt will decide for themselves that the US won't repay or a political decision needs to be made to return to fiscal solvency. Given the scope of the problem, in my view, cosmetic changes to the budget or debt process, like the now silly "debt ceiling" legislation will not be enough.

But, you might be thinking, the US public sector debt problem is not so big. I disagree. While the US debt to GDP ratio as currently calculated is not at the levels of, say, Iceland, it is much higher than the Treasury numbers suggest if expected entitlement payments are to be paid over the next few decades.

More importantly, the US Treasury Bond market is the focal point of all other US debt markets. An out of control Treasury Bond market will lend itself to greater volatility in all debt markets and vice versa. I have previously noted that the biggest single contributor to the widening current account deficit is the federal government. Bringing that corporation back in the fold of fiscal solvency would likely go a long way to weaning the nation off its abuse of the dollar as world reserve currency.

While I'm not an advocate of financial consolidation, I can see the virtues of the approach. Big problems often require big solutions. But big solutions sometimes create even bigger problems as France and England discovered.

In the end the ultimate outcome will depend upon the ethics and integrity of the people put in charge, the legal foundation upon which the new or modified institution stands and the willingness of the nation states involved to stay the course. To use a sports term, it's crunch time from a financial sense. I can't say I am hopeful but I do think it better to start throwing solutions out rather than burying our heads in the sand. There is, I believe, a cancer in the monetary system. The sooner it is dealt with the better.


jeff poppenhagen said...


Before we start to talk about solutions to the problem I think it best to begin with a discussion of the size of the problem. First, I don't think that we can limit the debt issue to government credit only, we must look at the total debt picture in the U.S. Next we need to be a bit more specific about how "too much debt" is to be be defined.

It strikes me as odd that no one that I know of has attempted to do this. It is odder still because I believe that there is a fairly simple way to calculate (roughly) the maximum amount of non-financial debt that a system can endure (that is if all of societal capital was lent into the debt market and equity issuance was zero).

We use non-financial debt instead of total debt because we don't want the double counting that comes with using financial debt. Second, over very long periods of time, interest rates on ten year government bonds equal nominal GDP growth (over the last 50 years this has come to about 6.5%). This makes sense in that those who have accumulated capital that can be lent out require a real rate of return plus some inflation coupon. The borrowers will access this pool of unconsumed capital until the marginal cost equals the marginal rate of return, and in a large, relatively open capital market system this means that most lending is done at the margin. Next, we can assume that all of the incremental output generated by society is used to service the debt. Given that we know that nominal GDP growth last year was about $760 billion, a little simple division using interest rates assumptions between 5% for current ten year bond rates and 6.5% for the 50 year average yields a maximum debt burden of somewhere $11.7 trillion and $15.2 trillion. If you assume that nominal GDP growth (in percentage terms)equals bond yields then nominal GDP should be equal to the level of non-financial debt in the system. This makes sense once we realize that non-financial debt is nothing but a claim on societal output. Nominal GDP today is about $13 trillion. The problem, of course, is that non-financial debt is $26 trillion, and this would still exclude the massive PV of all future liability payments. The debt level is at least 2x too high relative to the level of societal output.

When we talk about correcting this it is important to talk about how, and in what you time frame, the imbalance is to be corrected. Obviously, correcting such a problem over a very short period of time presents an insurmountable problem IMO. That solution implies, if we take output as relatively fixed over the short-term, that the adjustment would have to come in the price of debt securities. They would have to fall by half. The problem with this outcome is that every single leveraged financial institution would go bankrupt overnight, and that is if we kept GDP constant. This does not appear to be an option.

The other option means that the value of societal output must increase much faster than the pace of debt issuance for some rather lengthy period of time. If debt issuance rose 7% per year and we resolved the problem over ten years so that non-financial debt and GDP were both about $52 trillion in year 2016, GDP would have to grow about 15% per year. If real output growth was maintained at 3%, then we can assume that the prices of goods and services will have risen about 12% per year. Ouch.

In short, solutions to this problem will require massive societal dislocation and the winners (if there are any) and the losers will be very different depending on how the correction occurs, even if it resolved over the course of a decade. The scale of the imbalance is enormous and divying up the pain will see one heck of a battle. And while the reconciliation of the debt-output imbalance will be important, how to prevent such calamity in the future is even more important IMO. Gold may not win this battle, but its going to receive an awful lot of votes.